All investments require a careful evaluation of the risks compared to the rewards. Would you risk $5,000 to make $5? Probably not. Although this example might be extreme, an investor must always consider and weigh their risk to reward in any particular trade. An investor who sells options on futures must also consider the amount of margin of any particular trade. Margin is a deposit by the investor who is leveraging the futures contract. Margin is a financial guarantee required to ensure fulfillment of contract obligations. Margin is also called a performance bond.
Margin and Options
When you buy an option, your risk is the amount of premium you are paying at the time of purchase. The money is deducted from your account, so you do not have any margin. When you sell or write an option, you are collecting premium into the account, the amount the option-buyer paid. Since the option still has time to expiration, you are liable for the option. That is where margin comes in. (Stocks are not the only securities underlying options. Learn how to use FOREX options for profit and hedging, in Getting Started In Forex Options.)
Exchanges such as the Chicago Mercantile Exchange (CME) work with SPAN margin, having developed the SPAN software, which is available to individuals and brokerage firms for purchase. SPAN stands for the Standard Portfolio Analysis of Risk system used for calculating margin. SPAN is a great risk-management tool which helps in optimizing the risk/reward scenario and could possibly increase an investor's percentage return on their overall portfolio. It should be noted that not all brokerages give their clients SPAN minimum margins for trading their accounts.
Developed in 1988, the CME uses the SPAN system for calculating performance bond requirements. It was the first futures industry performance bond system ever to calculate requirements exclusively on the basis of overall portfolio risk. Since its implementation, SPAN has become the industry standard and is now the official performance bond mechanism of nearly every registered futures exchange and clearing organization in the United States, as well as at many global entities.
Let's consider a strategy in the bond market to better understand how SPAN can be used to monitor market volatility and probability of profit for the investor. For this example will use the 30-year bond futures contract which has been trading in a 10-point range over the past six months.We feel the market will continue this pattern for the next three months. Each point in the bond market is worth $1,000. That said, the market has been in-between 103 and 113 as the six months low and high. That calculates to a yield between 5.7457% and 4.9671%.
|February 9, 2004|
Our strategy is to sell a call spread above the high and a put spread below the low. The market currently is at 109. For the call spread we'll sell a three-point spread, selling the 115 call and buying the 118 call to limit our risk on the trade. For the put spread we will sell the 103 put and buy at the 100 put. With this type of strategy our risk is limited to only one side of the market but we are able to collect premiums from both sides. For this example we have been able to collect $640.63 for the call spread and $265.63 for the put spread, totaling $906.26. Our risk is three points or $3,000 less the $906.26 in collected premium, giving us a net risk of $2,093.74 plus commissions and fees.
Although we have a maximum risk of $2,093.74 plus commission and fees in this example, because there is three months to expiration we would not experience the full risk on this position due to time value of the options.
Using the downloaded daily data from the exchange we are able to see that our margin on the trade using SPAN is much less than the maximum risk. As we can see from this example we are only tying up $444 in initial margin to collect the $906.26 in premium. The initial margin is what is required to open the position, but that can and will change with the movement of the market. (There's one simple hurdle in the transition from stock to futures options: learning about product specifications. Find out more, in Options On Futures: A World Of Potential Profit.)
|March 17, 2004
Now let's say that a month has gone by and the market has climbed over five points and above the strike price of the call that we sold. The value in premium between call spread and put spread is now up to $1,468.75. We also see that the margin using SPAN has increased from $444-585. That is an unrealized loss of $562.49 and an increase in margin of $141. We are now approaching a point we would consider possible adjustments if the market does not retreat.
|April 22, 2004
Another month goes by and the market has dropped back within the range. There is approximately 30 days left to expiration and the premium between call spread and put spread has depreciated to $125 in value, giving us an unrealized gross return of $781.26. The margin on this particular trade is now to $398. The market has the ability to go and take back our unrealized profits since we have not closed out the position. Remember that the maximum risk on the trade is $3,000.
At this point with 30 days left to expiration, we can ultimately risk $3,000 to make $125. Although it is each individual investor's personal preference, we feel and that when the risk reward on any particular trade increases to this level, that it is better to close it out and re-enter the position in other contract month, and collect more premium with the same or less margin.
|May 7, 2004
With only 15 days left to expiration, the market has come close to the put spread that we are short. The premium between the call spread and put spread has increased to $296.87 and the margin has increased to $983.00. In two weeks the position gave back $171.87 in unrealized profit, and now we are tying up over twice the amount of margin. As mentioned before, the ultimate risk is $3,000, less the premium collected.
If the premium is less than what we originally collected, that is unrealized profit.
Reviewing the ratio between premium to SPAN margin, the investor needs to look at how much premium can be realized if expiring worthless to the SPAN margin. Once the margin amount has increased to an amount more than what can be realized as profit, one should consider closing the position.
How Much Should an Investor Risk on a Particular Trade?
It depends on each individual investor. What is your overall portfolio size? What is your risk tolerance? How much did you collect in premium compared to the overall risk in the trade? The rule of thumb is to risk one and one-half times what was collected in premium initially. That also depends on the type of trade you have placed. For this example we have collected about $900 in premium. That would mean we would look to risk about $1,450 in the trade. In a particular trade like this we would suggest limiting the risk to $1,000. If we follow the SPAN margin we can use that as a gauge to when we should exit our trade based on risk.
By using SPAN margin as a tool in our risk-management arsenal, we can increase our investor's probability of profit and lessen their risk. Although an investor might be leaving potential profits on the table, we feel that balancing those profits with stronger risk management is a better formula to success. (The options in Selecting A Hot SPOT Option allows investors to have full control over their investments.)